Venture Capital

What is venture capital?

Venture capital (German: Wagniskapital or Risikokapital, VC for short) is equity that specialised funds provide to young, unlisted companies with high growth potential. Equity means that the money is not repaid like a loan; in return the fund receives shares in the company, usually a minority stake (less than half). After some years, it intends to sell these shares at a profit. If the company fails, the fund's investment is generally lost; if a sale or stock market flotation succeeds, it can achieve a multiple of its investment.

Venture capital is a segment of unlisted equity investment capital. Unlike private equity in the narrower sense, which usually acquires majorities in established companies, it finances companies whose growth costs more money than the business itself generates. Those involved in a funding round are the fund, the founders and the existing shareholders. The key terms are first set out in a term sheet, a statement of intent that is usually non-binding in its core points. They are implemented in the participation agreement, in the shareholders' agreement (the agreement of the shareholders among themselves) and in the articles of association.

Structure of a venture capital fund

Initiators and investors

A venture capital fund collects capital from investors and invests it according to a defined strategy in a number of companies. The investors, called limited partners in the market, are for example insurers, professional pension schemes (Versorgungswerke), foundations, funds of funds (funds that in turn invest in funds), public development institutions, family offices and wealthy individuals. They commit an amount that is called down in stages as soon as the fund invests or pays costs.

The initiators (general partners) make the investment decisions and look after the holdings. They and their management company are usually referred to in everyday usage as the VC firm or venture capital company. In Germany the fund is often organised as a GmbH & Co. KG (a limited partnership with a GmbH as general partner). The investors are limited partners (Kommanditisten), so they are liable only up to their contribution. A general partner GmbH assumes personal liability, and a management company of the initiators runs the portfolio, that is, the whole of the holdings.

Management fee and carried interest

The initiators receive two kinds of remuneration. The management fee covers the ongoing costs of fund administration. During the investment phase it is often around 2% per year of the committed capital; afterwards a lower rate often applies, or a basis of the capital still invested.

The carried interest (profit share) accrues to the initiators only once the investors have received back their paid-in capital, often plus a preferred return (hurdle rate), that is, a minimum return on their capital. A share of around 20% of the profit beyond that is usual. The initiators therefore earn mainly from high exit proceeds and less from administration. For funds structured as asset-managing vehicles, the carried interest is 40% tax-exempt for the recipient under Section 3 no. 40a of the German Income Tax Act (Einkommensteuergesetz, EStG).

Term, investment phase and portfolio logic

The life cycle of a fund

Venture capital funds are closed-end funds with a fixed term: investors cannot demand their capital back early, and new investors no longer join after the fundraising phase. Around ten years with limited extension options are common. In the investment phase, often the first four to five years, the fund enters into new holdings. After that, it invests only in existing portfolio companies, for example through a follow-on investment in later rounds, and prepares the exits.

Portfolio logic and return expectations

A fund spreads its capital across a number of companies because it expects many failures. Some of the holdings fail, another returns the capital invested or little more. The fund's result usually depends on a few holdings whose value multiplies. This unequal distribution is called the power law.

From this follows the yardstick that funds apply to each new holding: it must have the potential to return a considerable part of the fund volume on its own. Market size and exit prospects therefore weigh as heavily in the review as the current figures.

Funding stages with venture capital

Venture capital accompanies companies through several funding rounds, which are named in the market on the US model:

• Pre-seed and seed: product development and first customers, often financed by business angels (angel investor), early-stage funds and public programmes.
• Series A: first larger round with institutional investors, that is, funds, once the product has been accepted by the market.
• Series B: expansion of sales, organisation and markets.
• Series C and later rounds: internationalisation and acquisitions, often also with growth funds and strategic investors.

With each round, round size and valuation generally rise, and the review shifts from team and market size to revenue quality and metrics. Funds usually specialise in particular stages.

Legal framework for venture capital in Germany

Regulation of the fund

Under the German Capital Investment Code (Kapitalanlagegesetzbuch, KAGB), venture capital funds are generally alternative investment funds, that is, funds outside the classic securities funds for retail investors. They are managed by investment management companies, which in principle need a licence from the German Federal Financial Supervisory Authority (BaFin). For smaller managers below certain thresholds, registration is often sufficient. The European fund label EuVECA (European Venture Capital Fund) facilitates distribution in other EU states.

Implementation of the investment in the GmbH

In a GmbH (German limited liability company), the fund generally acquires its holding through a capital increase. The shareholders' meeting resolves it with a majority of three quarters of the votes cast, the resolution is notarised, and the capital increase takes effect on entry in the commercial register. The nominal amount with which a new business share participates in the share capital is often only EUR 1. The far greater part of the investment amount flows as a premium (agio) into the capital reserve.

The fund's rights are set out in the shareholders' agreement and partly in the articles of association. Customary are a liquidation preference (priority on the sale proceeds), anti-dilution protection for the case that later shares are issued at a lower price, and consent requirements under which material decisions need its approval. In addition there are information rights, a seat or observer status on the advisory board (a voluntary supervisory and advisory body of the GmbH) and provisions on tag-along rights and drag-along obligations.

Worked example: return of a venture capital fund

A fund has EUR 100 million of committed capital and a term of ten years. It takes stakes in 20 companies. For simplicity, preferred return, other fund costs and the timing of the payments are disregarded.

• Management fee: 2% per year in the first five years, 1% in the following five years: 5 × EUR 2 million + 5 × EUR 1 million = EUR 15 million
• Available for holdings: EUR 100 million minus EUR 15 million = EUR 85 million
• Proceeds: twelve holdings together bring EUR 15 million, seven together EUR 60 million, one alone EUR 150 million; in total EUR 225 million
• Profit above the paid-in capital: EUR 225 million minus EUR 100 million = EUR 125 million
• Initiators' carried interest: 20% of EUR 125 million = EUR 25 million
• Payout to the investors: EUR 225 million minus EUR 25 million = EUR 200 million, that is, twice their paid-in capital
• Share of the most successful holding in total proceeds: EUR 150 million divided by EUR 225 million = about 67%

Without this one holding, the fund would have realised EUR 75 million and not even returned the paid-in capital. If the fund holds 12% at the sale, the company must arithmetically be worth EUR 1.25 billion for this return (EUR 150 million divided by 0.12).

Distinction: venture capital, private equity and other capital providers

• Private equity: usually acquires majorities in established, profitable companies and partly finances the purchase price with debt; venture capital holds minorities in growth companies.
• Angel investor: invests own assets, usually earlier and in smaller amounts. A fund invests its investors' capital and is bound by the fund agreement and term.
• Corporate venture capital: holdings of an established company that, alongside the return, pursue a strategic benefit for the company's own business.
• Family office: invests family wealth without a fixed fund term and can therefore hold investments for longer.

Common mistakes

• Venture capital for an unsuitable model. A company with steady profit, a limited market and no intention to sell does not fit the return logic of a fund. The question belongs before the first approach, not in the negotiation of the term sheet.
• Valuation as the only negotiation goal. A high valuation with a multiple liquidation preference or far-reaching consent requirements can yield less on a sale than a lower valuation with market-standard terms.
• Fund term not checked. A fund near the end of its investment phase often has no funds for follow-on rounds; one near the end of its term pushes for an early sale.
• Dilution calculated only for the next round. Venture capital usually finances several rounds in succession. Anyone who looks only at the upcoming round underestimates how far the founders' stake falls by the time of a sale.
• Disorderly shareholder structure. Oral promises of shares, unconverted loans and missing documents are noticed in due diligence, the investor's review of the company, and delay the round.

Frequently asked questions

From what company size does venture capital come into question?

There is no fixed lower limit. What matters is whether the business model allows growth to be expected that makes a multiplication of the company value within the fund term plausible.

How many shares does a company give up in a round?

That follows from the capital requirement and valuation. The new investors' stake corresponds to the investment amount divided by the valuation after the round (post-money), that is, the valuation before the round plus the new capital. As a rule of thumb, the stake given up in early institutional rounds lies between 15 and 25%. An increase of the employee participation programme may be added.

How does a company get venture capital?

Through targeted approaches to funds whose stage, industry and holding size fit the company. A pitch deck, a financial model and, for the review, a complete data room are expected. The funds review in several stages, present a term sheet if interested and decide finally after due diligence. From preparation to closing, 6 to 8 months generally pass.

Does a fund have to sell its holdings after ten years?

In principle yes, at the latest at the end of the term including any extensions. For holdings still held then, the options are a sale to other investors or transfer to a new fund vehicle of the same initiators. Because the latter are on both sides, the transfer generally needs the investors' consent.

Does a venture capital fund obtain the majority?

As a rule not. After a round, funds usually hold minority stakes and secure their influence through consent requirements, advisory board seats and information rights. If the investors together hold more than a quarter of the votes (blocking minority), however, amendments to the articles of association, including capital increases, which require three quarters of the votes cast, are no longer possible against them.

The Roemer Capital view

Before we prepare a funding round from EUR 1 million, we clarify whether venture capital fits the business model and the shareholders' goals. A company can be capital-capable, that is, able to service loans, without being investor-ready, that is, structurally able to grow disproportionately with external equity. Only in the second case are venture capital providers the right partners.

In selecting contacts, we consider, alongside an investor's industry and stage, also its volume, the state of its investment phase and the reserves available. In the negotiation, we stand exclusively on the company's side.